Trade policy under endogenous credibility
Because trade liberalization which is anticipated to be temporary creates a divergence between the effective domestic rate of interest and the world rate of interest, tariff-reduction in the presence of international financial asset trade may reduce welfare for a small country. Calvo has argued that even though the government intends to liberalize trade permanently, if the private sector believes with some probability that a tariff will be imposed in the future, then free trade may not be optimal. This paper first formalizes this argument and discusses the optimal policy for a government which seeks to maximize representative household welfare. The government's lack of credibility is represented by a set of beliefs the private sector holds about the type of government it faces. Next, beliefs are endoqenized by allowing me private sector to update them using Bayes' rule. In one approach, the true government's objective is maximize welfare for the economy, so that it does not seek to imitate another type, in contrast with other recent models of policy credibility. With learning, the government eventually adopts free trade, even though restricted trade is optimal initially.
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- Backus, David & Driffill, John, 1985.
"Inflation and Reputation,"
American Economic Review,
American Economic Association, vol. 75(3), pages 530-38, June.
- Robert J. Barro & David B. Gordon, 1983.
"Rules, Discretion and Reputation in a Model of Monetary Policy,"
NBER Working Papers
1079, National Bureau of Economic Research, Inc.
- Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
- David Backus & John Driffill, 1985. "Rational Expectations and Policy Credibility Following a Change in Regime," Review of Economic Studies, Oxford University Press, vol. 52(2), pages 211-221.
- Calvo, Guillermo A, 1986. "Temporary Stabilization: Predetermined Exchange Rates," Journal of Political Economy, University of Chicago Press, vol. 94(6), pages 1319-29, December.
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